Why Paulson’s Plan Falls Short

The regulatory framework proposed by Treasury Secretary Henry Paulson will not address fundamental problems in the banking sector that contributed significantly to the recession and that must be fixed to rescue the U.S. economy from recession and avoid future crises.

The banks and securities companies, essentially, created overly complex and risky securities when bundling subprime mortgages and other loans into bonds. The banks became engaged in bogus, off books operations and credit default swaps that proved less than worthy. Ultimately, the value of these bonds collapsed, as investors could not adequately evaluate those bonds and discount for their risks.

Now fixed income investors no longer trust the credibility of the banks and securities companies, and these firms can no longer bundle mortgages, consumer loans and business loans into bonds, giving rise to the current credit shortage.

Even with a lower fed funds rate and beefed up access to the discount window, banks lack the credibility to raise funds in the fixed income market to make loans adequate to power the economy out of recession.

The regulatory reform and reorganization proposed by Secretary Paulson would enhance the Federal Reserve’s access to information about investment bank and securities companies activities, and subject many to stricter prudential financial standards; however, it does little to constrain the banks and securities from the kinds of abuses that gave rise to the current crisis. Nor does his plan provide adequate safeguard to avoid future credit crises and recessions from a recurrence of securitization abuses.

Further, Paulson’s plan does not address the problem of the bond rating agencies. Rating services are paid by the banks and securities companies to rate the bonds created by those companies. This has proven a flawed model that Paulson seems unwilling to address.

PETER MORICI is a professor at the University of Maryland School of Business and former chief economist at the U.S. International Trade Commission.